Financial Health Ratios: Solvency Ratios

Video Transcription:

In this lesson we are going to start to talk about the financial health ratios, and we are going to divide this lesson into two because we are dividing the financial health ratios into two categories, but first of all let’s start by defining what financial health ratios are.

Financial health ratios will help you determine how strong a company is, the strength of a company is indicated by its ability to pay its debts, suppliers, taxes, etc. In other words financial health ratios will give investors an idea of how liquid and solvent a company is. Liquidity and solvency ratios are the way to calculate a company’s risk of bankruptcy. We are going to divide the financial health ratios into two categories, liquidity and solvency ratios.

We are going to start by solvency ratios. When we talk about solvency ratios, we refer to a company’s capacity to bid its long term financial commitments. A solvent company is one that owns more than it owes. When we are calculating solvency ratios, we are looking at a company’s long term financial health, and how solvent this company is to be able to pay its long term financial commitments.

We are going to start by the debt to equity ratio. This ratio indicates the degree of financial leverage being used, and it includes both short term and long term debt. A rising debt to equity ratio implies higher interest expenses, and the interest expenses are the cost of borrowing money, or the interest that a company has to pay over its outstanding debt. So a rising debt to equity ratio implies higher interest expenses, which can lead to affect a company’s credit rating.

Downgrading a company’s credit rating will make it more expensive for the company to borrow money in the future. This means that it will have a higher debt to equity ratio, which will lead again to a downgrade in the company’s credit rating, etc. A rising debt to equity ratio is something not to be trifled with because it can go down in to a very costly spiral. So before we left for debt to equity ratio is the total debt divided by the total equity.

The debt to equity ratio differs from sector to sector because some industries have to have a higher debt load than others to support its day to day operations. For example a manufacturing company is going to have a higher debt load than a software company. So its debt to equity ratio is going to be higher, but this doesn’t mean that the first company is not going to be unable to pay its interest and expenses. Because the debt to equity ratio differs from sector to sector.

The second solvency ratio we are going to go through is the debt to asset ratio, this ratio calculates the percentage of a company’s assets that have been financed with debt. This ratio also used short and long term debt to calculate it. A high debt to asset ratio indicates a high degree of leverage, which means that the company had to finance a high percentage of its assets to be able to operate. A high degree of leverage indicates a greater financial risk for investors because a higher degree of leverage is just a higher degree of debt, or a higher debt load. The formula for the debt to asset ratio is the total debt divided by the total assets.

The third ratio we are going to learn in this category is interest cover ratio, this ratio indicates how easy it is for a company to pay its interest expense on its debt with its operating income, which is basically its earnings before interest and tax. The operating income is the company’s realized profit from the sale of its products or services after taking out the operating costs such as stock depreciation, salaries, etc. So basically what this ratio indicates is how solvent the company is to face the payment of interest on its outstanding debt.

The higher the ratio the better the company’s ability to cover its interest expense that means that the higher the ratio the more solvent this company is. The formula to calculate the interest cover ratio is operating income divided by interest expense. Solvency ratios will help investors understand the overall financial risk of investing in a company, and its overall bankruptcy risk.

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